The Consumer Price Index for All Urban Consumers (CPI-U) declined 0.4% in December on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 0.8%.

From August until the end of 2014, US prices fell 0.7%. December’s sharp decline was primarily caused by a massive 9.4% drop in the price of gasoline, which is down 21% in the last 12 months. Fuel oil was down 7.4%. Food prices, however, rose 0.3%. The shelter index rose 0.2%, and the index for medical care commodities was up a sharp 1.0%.

What this means for TIPS and I Bonds. Today’s inflation report isn’t welcome news for holders of Treasury Inflation-Protected Securities and I Bonds. Non-seasonally adjusted CPI-U – which fell 0.57% in December – is used to adjust the principal balance of TIPS and set future interest rates for I Bonds. The December inflation index was set at 234.812, below where it stood in March 2014 (236.293). In just three months, from September to December 2014, non-seasonally adjusted CPI has dropped 1.36%.

This is setting up a problem for I Bonds in 2015. I Bonds purchased through April 30 pay a fixed rate of 0.0% and an inflation-adjusted rate of 1.48% annualized. The next adjustment for the inflation -adjusted rate – on May 1 – will be determined by inflation from September 2014 to March 2015. Three months in, that’s running -1.36%, so it looks highly likely that I Bonds will get an inflation-adjusted rate of 0.0% on May 1, to go along with a fixed rate that may hold at 0.0%. In other words, zero + zero = zero.

What this means: Do not plan on buying your 2015 allocation of I Bonds ($10,000 per person per calendar year) until late in the year, after the Nov. 1 adjustment.

Core inflation. Even when you strip out food and energy, US inflation was unchanged in December and rose 1.6% over the last 12 months. This is well below the Federal Reserve’s target of 2.0% annual inflation, and should allow the Fed to continue holding the line on near-zero short-term interest rates.

Year in review. CPI-U rose 0.8% in 2014 after a 1.5% increase in 2013. This is the second-smallest December-December increase in the last 50 years, trailing only the 0.1% increase in 2008. The BLS noted it is considerably lower than the 2.1% average annual increase over the last ten years. This chart shows the deflationary trend as gasoline prices fell sharply in the second half of the year:

10 Responses to Deflation continues: US prices fell another 0.4% in December

Assuming CPI printed negative for the 2015 tax year, what are the IRS rules on how you report the negative OID on your tax filing? I do believe that you have the option to declare OID interest as ordinary interest. But, can you use negative OID to offset your all interest income? I think that solves the problem in a lot of situations, as many people have other sources of interest income. But, what if the offset limited to the coupon of the individual TIPs? If the latter, this could be a problem for anyone who bought recent TIPS, many of which went out with a .125% coupon. If CPI was down more than .125, you might not get to fully offset the negative OID. Part of the problem is that even if you can do the “all interest” offset, I’m not sure that TurboTax is set up to do that — I think it goes bond by bond, or at least it used to. Any thoughts on this — I think there were some years in 2008 -2010 where CPI was negative YOY, but I don’t think the problem came up, because the TIPS coupons were around 1% -2%% back then.

Thanks for the tip Dave. I’m wondering what will happen to deflation/inflation psychology when oil prices eventually recover, boosting pump prices and the CPI over several months. How will consumers business and the media process the news? My guess is they’ll largely ignore the subtleties (core vs. total, shifts vs. trends, etc.) and mostly see it as “inflation is back”. If so then with all the cash on hand, that perception could translate into actual demand and inflation pretty quick. I know this is a contrarian view but the assumptions seem reasonable so I’m not sure why that is. Anyway for fun I’ll throw out a prediction: Oil at $80 by May, CPI up 4% YTD by July and 6% annually by December, and the Fed will have to rein in pretty hard to hold it to that!

I think you are “right too soon,” but you raise a good point — the psychology now is that inflation is dead, which is a very good contrarian argument in favor of TIPS. The problems is that TIPS are subject to other psychological factors right now, which I think are considerably more powerful, such as flight to safety, which are seriously depressing yields. My take is that these non-inflation factors, particularly flight to safety, make TIPS a pretty bad deal right now. If you are a Russian plutocrat looking for safety, TIPS are a marginally better buy at this point than are nominal T-bonds, but that’s about it. This is not the Golden Age for TIPS investors.

The market may not be perfectly efficient but I don’t think it’s that dumb either. The low inflation breakeven all along the yield curve is telling us something about future inflation expectations. Tips are priced based on the world not what you or I have to pay for gas. The market anticipates low inflation/deflation. If something unexpected happens, the market will be wrong, but since by definition it will be unexpected, there’s no way for someone lacking inside info like Soros to predict it. Otherwise it’s just a guess or a gamble. If you really think oil is going up in that time frame with any degree of confidence forget Tips entirely, and go trade oil futures, and I’m not trying to be sarcastic. Your willingness to actually make a trade on your prediction is a measure of your conviction At times like these I don’t have much conviction about anything. It’s difficult to know what to do but we have to accept that the market is predicting low inflation for the foreseeable future and that prediction is generally consistent with what’s been happening elsewhere in the world economy.

MGK … >>But, can you use negative OID to offset your all interest income?>>

Definitely. Negative OID will offset other interest gains, in your overall portfolio. As I recall, it is simply a negative number that gets plugged into the IRS form. However, inflation is still net positive for 2014, so that won’t happen for the 2015 filing.

John P … We had a gasoline-related boost to inflation a few years back and it didn’t cause a lot of inflationary fear. When gas prices rise sharply, it really cuts into other consumer spending, which is deflationary for the rest of the economy. I know a lot of people are down on TIPS right now because of this temporary deflation, but when gas prices rise – and they will – all this deflation will be reversed. And I believe that will happen in the next 5 years, easily.

Any projected inflationary effect of future rising gas prices has already been priced into the TIPS market. They will only protect against unexpected inflation, not probabilistic projections such as using existing known information to make these kind of educated guesses. It has to be something unexpected hence unpredictable. Whatever the value of tips “should” be, it’s a continuous arbitrage against other financial assets. One of those assets right now is Swiss francs in which currently pay (.75)% interest. Now THAT’s deflationary. Now would be a good time to turn on the printing presses with a lot of stimulus and maybe use it to rebuild crumbling infrastructure, if we wait too long it will be much harder to extract from this deflationary cycle, maybe Krugman was is right, bite my tongue.

While what you say is valid from an economic standpoint, the market price averages all of the different views, which can be misleading, especially in the case of inflation, which can have a very fat tail on the high side. In that sense, what you are really buying with tips now are very cheap out of the money puts on high inflation, which still seems to me like the best reason to go for a long duration tips. Markets tend consistently to underprice tail risks, which I think are quite large for inflation.

YM, you wrote, “At times like these I don’t have much conviction about anything.” I totally agree. I view TIPS as a super-safe investment and not much of a gamble in this risky world. If there is higher-than-expected inflation, they pay off. If there isn’t, they are still an acceptable if somewhat lousy investment, held to maturity.

If nothing else, the last couple of years have been an educational experience with regards to worst case scenarios for investing in TIPS. Up until recently, negative TIP YTM’s and the possibility of losing principle due to deflation by buying TIPS above par were merely academic exercises. For example, take the 5-year TIPS re-issue from last December. For the inflation adjusted purchase price of that $1,000 par value was $1,001.75 on the settlement date of 12/31/14. The current inflation adjusted “book” value of that same bond today is $998.87. So, if deflation continues thru the term of that bond, kiss $1.75 goodbye! On the other hand, the market value of that same bond is $1,016.22. That’s a gain of $14.47. That represents over 10 years worth of interest! That’s a real gain of 1.4% in less than a month (32.5% annualized). With 2014’s CPI-U below 1%, that’ not a bad return for one moth. A bond traders paradise!

Jimbo, yes, the volatility of TIPS in the last five years has made trading potentially profitable. I don’t trade them, though, just buy (carefully) and hold. Eventually, the trading potential will wither when (if) ultra-low yields rise to more normal levels. I can’t argue with taking profits, especially if you have another investment in mind.